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Fixed or Variable Rate Mortgage

cautious confident afraidFixed or Variable Rate Mortgage

Most people select a five year term when buying, renewing or refinancing their mortgage. And the majority select a fixed rate mortgage over a variable rate mortgage (VRM).  Why is that?

Which way to go is probably one of the questions we are asked most frequently in the mortgage business. There are so many opinions out there by people with lots of industry knowledge and even more opinions can be found from your friends and colleagues.  Let’s clear up first what we are talking about.

A closed, fixed rate mortgage means your interest rate is guaranteed to stay the same for as long as your mortgage term. Which also means your payments will stay exactly the same too – unless you choose to increase them yourself.

With variable rate mortgages [some lenders call them adjustable rate mortgages (ARM)], their interest rate can go up or down during the term of your mortgage. Your rate is determined as a discount (usually) to the Bank of Canada Prime Interest Rate.

Most such mortgages adjust their payment with changes in the Prime Rate. The result being if you have a VRM you either won’t have certainty of how much your future mortgage payments will be; or if you do, you won’t know in advance what your remaining mortgage balance will be.

Here is an example. Today the Prime Rate is 2.85%. A reasonable VRM would be priced at Prime less 0.65% =è 2.2%. Meanwhile, a reasonable five year fixed rate mortgage today is 2.69%.

Someone choosing to go variable is “saving” half a percent in interest. Historically, a VRM has been attractive to more borrowers when the difference has been more than one percent.  I suppose this is because people want the maximum reward possible for giving up the certainty and peace of mind offered by fixed rate mortgages.

This way or that wayIt’s the same reason many borrowers last year took out ten year fixed rate mortgages when they were as low as 3.69% – it’s a form of insurance – protection against rising interest rates during the term of your mortgage.

You should know it has been a winning strategy to choose variable for many years. There’s no specific reason that will change. As a practical matter though, it’s worth noting rates today have more room to rise than they do to fall.

Another reason to select a variable rate mortgage is to avoid potentially high prepayment expenses if you have to break your mortgage before it matures. Most VRM’s will only charge three months’ interest, whereas fixed rate mortgages can incur a much higher cost.

Related Article: You should understand mortgage prepayment penalties

So who is right and who is wrong? No one actually! We’ll only know well after the fact. And even then, who knows. Borrowers with a variable rate mortgage always have the ability to convert to a fixed rate mortgage at any time – so even if rates climb a great deal, many VRM borrowers will jump ship.

In my view, the decision should not be based on your favorite economist’s view of interest rates over the next several years – since no one ever seems to be right about that!

conservative and cautiousIf I sense I am with a conservative who really would not have the stomach for rising rates with a VRM, I nudge them towards fixed. (They want me to do that – they just don’t know it)

If they have no strong feelings on the matter, or are looking to us for advice, we would more than likely steer them towards a fixed rate mortgage too. That does not mean we are pessimistic about the outlook for interest rates. It just makes sense not to direct people towards uncertainty if we don’t have a good reason to.

These days we find clients selecting variable rate mortgages tend to be sophisticated borrowers, and they are usually not first time buyers. They are well aware of the risks, and they are confident in their decision and their ability to weather any foreseeable development. Also, it’s easier to ‘roll the dice’ if the actual mortgage amount is small, relative to your overall net worth.

So there you are – it’s a personal, individual decision which I feel should be based as much on your risk/reward profile as anything else. If you really are not sure, I would lean towards a five years, fixed rate mortgage with a lender who has very favorable prepayment privileges, just in case you have to break your mortgage before it matures.

Related Article: Variable rate mortgages can be harder to qualify for

Related Article: The risks of variable rate mortgages by Rob McLister

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